How to Focus on Comparative Advantage while Efficiently Diversifying Economic Risks: An Application of Modern Financial Technology

Robert Merton (2004)

How to Focus on Comparative Advantage while Efficiently Diversifying Economic Risks: An Application of Modern Financial Technology

Abstract

One of the classic economic tradeoffs is between following the fundamental dictum to pursue comparative advantage which generally requires focus on a few related activities and implementing the equally fundamental dictum of efficient risk diversification which requires engagement in many, relatively unrelated activities. Modern financial technology makes it possible to separate risk-exposure selection and management from the choice of physical and capital expenditure plans. It is now feasible to radically change risk exposures without affecting capital, trade or income flows or the stock of assets or liabilities. Market-accepted financial technology exists that makes it possible to do so in much larger size and at much lower cost than in the not-too-distant past. Thus, as a practical matter, risk is now a separable dimension of management desicions.

In my remarks, I will develop and illustrate the idea of using financial technology to greatly reduce or even eliminate altogether this classic tradeoff in a series of examples at the levels of the firm, the financial institution, and the entire country. I close with some observations on implications of these new technologies for private-sector management and implementing public-sector economic policies.